Searching for Buried Treasure in the Financial Markets using a Value Investing Approach

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Is the U.S. Stock Market Currently in a Bubble? (Part 1)

The question of whether the U.S. stock market is currently a bubble waiting to burst or at least overvalued is a subject of much debate these days. There are arguments that can be made supporting both opinions. I think it’s less a question of whether the market as a whole is overvalued, but that some sectors are much more richly valued than others. Comparing market valuation measures now to years in which we had sharp sell-offs will also be instructive. Let’s look at evidence that can help us decide.

The S&P 500 gained 32% for investors in 2013 including dividends and the Nasdaq Composite gained 37%. The Nasdaq Internet Index gained 63% in the 12 months ending March 6, 2014 and is currently down 17% from its peak. The Nasdaq Biotech Index gained 86% in the 12 months ending February 27, 2014 and is currently down 17% from its peak. Compare that to the Nasdaq in 2000, which rose 110% in the 12 months before the dot-com bubble peaked on March 10, 2000. One of the signs of a bubble is a rapid rise in prices due to a new technology or innovation. Internet stocks and biotechnology stocks have definitely exhibited stratospheric rises in price, so those sectors at least might qualify as being very overvalued.

Nasdaq Internet Index

Nasdaq Biotech Index

Let’s look at some valuation metrics that will give us an idea of how richly valued the current market is. In the first part of this post, we’ll look at the Schiller P/E.

The Schiller P/E Ratio

Looking at price alone is one-dimensional so lets see how expensive the market is on a basis relative to earnings, a.k.a the familiar P/E ratio. Most analysts look at P/E ratios with earnings of the past year or earnings for the next year, however this doesn’t take into account the crests and troughs of the business cycle which vary over the years. If the economy is healthy, corporate profit margins should be higher, while if the economy is in contraction, profit margins should be lower. The best way to compare P/E’s over the years is to take an average over several years that give us a good sample of earnings over many business cycles. Hence we have the Schiller P/E, developed by Yale economist Robert Schiller.

The Schiller P/E uses the annual earnings of S&P 500 companies over 10 years and is adjusted for changes in the CPI to be translated to today’s dollars. The price in the numerator of the Schiller P/E is just the current price of the S&P 500. If you’re interested in the details, the link below provides more detail about the Schiller P/E, how it’s calculated and why it’s a superior measurement tool.

Below is a chart of the current value and history of the Schiller P/E, which right now is about 25, higher than its mean value of 16.5. The Schiller P/E surpassed 44 during the dot-com bubble.

Source: GuruFocus.com

As some of us can remember, the markets in the late 1990’s were very skewed by the exorbitant prices of tech stocks. However, John Hussman, stock analyst and fund manager, says that the price to revenue ratio of the median stock in the S&P 500 now is higher than it was in 2000. (http://www.hussmanfunds.com/wmc/wmc140428.htm)

Here’s a similar chart below from Robert Schiller’s website that shows the Schiller P/E and long-term interest rates over the years. Notice how the P/E is the highest it’s been since 1929 during the Great Depression and the year 2000 when we had the dot-com crash.

Source: Home Page of Robert Schiller

Does this mean that a crash is imminent? No. It just means that stocks aren’t as cheap as in the past. It also shows that the low interest rate environment may have had a huge impact in the recent run up in stock prices. Rates really have nowhere to go but up from here. It begs the question of what will happen to stocks once the inevitable increase in rates occurs. They’ve been held artificially low for a long time, thereby distorting asset prices. For example, money-losing companies that should have gone out of business years ago are able to continue to obtain cheap financing at low rates to stay alive, so the market isn’t able to act naturally as a clearing mechanism. The low rates have also encouraged and forced investors to “reach for yield”, investing in assets which are more risky and speculative for a few more basis points in potential return.

Stay tuned for part 2 of this blog post where I’ll look at some other metrics that’ll give us an idea of the current state of the market.